This article first appeared in The Edge Financial Daily, on October 29, 2015.

Sector Focus: Food and Beverage

In a more challenging market and economic environment, we like the food and beverage (F&B) sector for its resilience and defensive qualities. To be sure, not all F&B players are resilient. The retail restaurant players, for instance, are expected to be badly hit as consumers tighten their belts. Generally, we would categorize the Malaysian F&B sector into three main segments:   

1.     Snack and confectionary companies with established brand names, and are export-oriented.

2.     F&B companies with strong domestic brand names, where demand is generally inelastic.

3.     Retail restaurant-based F&B companies.

We like the first two sub-sectors, and are negative on the third sub-sector.

In particular, we like Malaysian snack and confectionary companies with established brand names, and a growing exposure to the export market. Growing exports — especially to other, faster growing countries in the region — is a significant positive feature in many of these companies, as the Malaysian market is relatively small. Plus, the weak ringgit has given a boost to margins.

There are quite a number of these companies, which we will look at in the coming days, starting with Cocoaland Holdings.

These companies have differentiated themselves in terms of product range (such as confectionary, biscuits and jelly beans), market segment and export base. They have carved their names not just domestically but also across the region, especially to the faster growing developing countries where their products are highly competitive and income levels are rising at a fast clip.

The competitive advantage of these F&B companies arise from a low-cost based operation in Malaysia, trusted brand names built over decades and continuous product innovation to cater to changing tastes. This gives them an upper hand over high-cost products from the US, Europe, Australia and Japan. For some companies, exports account for as high as 60% of total sales.

With the ringgit’s depreciation (down 17.6% year-to-date versus the USD), these companies should see stronger earnings and margins from their USD-denominated exports, while at the same time benefitting from lower raw material costs. P/E valuations for stocks in the sector typically range from 13-22 times, with decent yields of 2.4-5.0%.

The prices of key agriculture commodities have fallen sharply this year as slowing growth in China weighed down on global commodity prices. Year-to-date, the price of wheat has fallen by 17.2%, sugar by 10.8%, coffee by 33.8% while cocoa price has increased by 11.2%, and palm oil by 2.4%.  

The second segment of the F&B sector comprises companies with strong brand names (such as Nestle and F&N), that derive most of their earnings domestically. These companies already have a strong captive domestic market and relatively inelastic demand, irrespective of economic conditions. They will also benefit from lower commodity prices, as noted earlier, while a dominant market positioning protects pricing power for end products.

Many of the stocks in this segment have higher P/E ratios of 21-29 times, but resilient earnings and attractive dividend yields of 3.0% to 4.6%, due to strong cash flows and low capex.  

Last but not least, we are underweight on retail F&B companies that are primarily restaurant based, with insignificant export contributions. These companies are expected to be hit by weaker consumer spending, amid the goods and services tax (GST), higher cost of living and increasing retrenchments. Already, retail sales for 2Q2015 showed the worst fall since 1998, down 11.9% y-o-y. Companies in this category would include Old Town.

There are quite a number of F&B stocks in the first two sub-sectors that we believe can outperform the market in a challenging environment. The first stock we will look at is snacks and candy maker Cocoaland (Fundamental: 2.8/3, Valuation: 1.7/3).